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In what is becoming a familiar market situation (see the Fed circa 2013/2014), the ECB has the unenviable task of starting to repeal some of the monetary stimulus it has dished out over the last decade, without the market jumping to wild conclusions about its medium-term intentions. What is clear from recent price action over the last 24 hours is that we could see some out-sized moves in EUR/USD, up over 1.5% in less than 24 hours, relative to fundamental explanation, especially as we come into the summer months which is historically characterised by lower volumes and higher volatility.
For what it’s worth, we think it’s always worth reminding ourselves of the ECB’s key criteria for judging monetary policy when headline inflation overshoots. The four principal questions are that the policy horizon should be judged over the medium-term, inflation should be self–sustaining, should not be temporary and similar across the whole of the Eurozone.
So which boxes can we tick? Yesterday, Draghi stated that some central bank support will be needed to remain in place as the rise in inflationary pressures was ‘not yet durable and self-sustaining’. He went further to say there needs to be persistence and prudence in the ECB’s future policy path when adjusting for improving economic conditions. We note that the pace of wage growth is still fairly moderate and uneven inflation is prevalent across the continent. In addition, one of the ECB’s favourite gauges of inflation expectations is still some way off target at 1.81%.
With all that said, the market reaction has been pronounced and EUR/USD is now touching overnight highs around 1.1381 having also been given a boost by Carney’s apparent ‘volte-face’. It has also ignored an ECB sources story saying the market has overreacted to Draghi’s comments. When a market is caught off-guard, then the focus turns to the general bullish assessment of the Eurozone recovery and it’s no doubt that many market participants have gone into overdrive over the ECB / Mario Draghi using the word ‘reflationary’.
This potential move towards tapering in September will of course also help the ECB’s euro bond buying programme as it’s only a few months away from reaching its limit in German bonds. In essence, many believe it is acknowledgment by the central bank that the removal of accommodative policy is finally on its way, even when allowing for the current low volatility environment.
EUR/USD Daily Candle Chart
Regarding EUR/USD, it’s very hard to argue against price action near-term. Having range traded between 1.11 and 1.13 for the previous 6 weeks, we smashed through the 1.13 level yesterday breaking to new 2017 highs. We have now had bullish consolidation today and this indicates solid support on dips going forward. Trend indicators are bullish and in this scenario, any correction should be shallow, whilst holding above 1.13. A measured move indicates trading to 1.15 in the medium-term with multi-month highs around 1.1425 along the road. The market is certainly not blinking at the moment at Draghi’s comments made yesterday.
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